Working Paper

Title: Foreign Direct Investment and Currency Hedging

Reference Number: 1180

Publication Date: December 2007

JEL Classifcation: D81, F23, F31

Author(s):

Kit Pong WongThe University of Hong Kong

Abstract:

This paper examines the behavior of a risk-averse multinational firm (MNF) under exchange rate uncertainty. The MNF has an investment opportunity in a foreign country. To hedge the exchange rate risk, the MNF can avail itself of customized derivative contracts that are fairly priced. Foreign direct investment (FDI) is irreversible and costly expandable in that the MNF can acquire additional capital at a higher unit price after the spot exchange rate has been publicly revealed. The MNF as such possesses a real (call) option that is rationally exercised whenever the foreign currency has been substantially appreciated relative to the domestic currency. The ex-post exercise of the real option convexifies the MNF's ex-ante domestic currency profit with respect to the random spot exchange rate, thereby calling for the use of currency options as a hedging instrument. We show that the MNF's optimal initial level of sequential FDI is always lower than that of lumpy FDI, while the expected optimal aggregate level of sequential FDI can be higher or lower than that of lumpy FDI. We further show that currency hedging, no matter perfect or imperfect, improves the MNF's ex-ante and ex-post incentives to make FDI, a result consistent with the complementary nature of operational and financial hedging strategies.